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Stock Returns: Searching High and Low

ETFs are surging in popularity.

Stocks are starting the week lower, with the Dow Jones Industrial Average(DJINDICES:^DJI) and the broader S&P 500(SNPINDEX:^GSPC) both down 0.5% as of 10 a.m. EST.

Returns: Searching high and lowInvestors poured $265 billion into exchange-traded funds and products last year, pushing total assets close to $2 trillion -- a record high, according to consulting firm ETFGI. The biggest winners were, in decreasing order of inflows: BlackRock(NYSE:BLK) (with its iShares unit), Vanguard, and State Street Global Advisors. The three firms consolidated their positions at the top of industry, snapping up more than two-thirds of total inflows.

Despite the poor performance of U.S. stocks during the 2000s, the appeal of passive investing (i.e., index following) is clear. In its "Mid-Year 2012 S&P Indices Versus Active" report, S&P Indices found that nearly two-thirds of large-cap active managers trailed the S&P 500 over the prior five-year period. Picking the winners is no easy task, as most don't remain on top for long; of the 707 U.S. equity funds in the top quartile in September 2010, just 10% remained there two years later.

Access to low-cost, passive investing via ETFs is, on the whole, an excellent development. However, the liquidity and ease of access of these funds can mask the characteristics of the underlying markets. Junk bond ETFs surged in popularity last year, but the bonds in the SPDR Barclays High Yield Bond ETF(NYSEMKT:JNK) are not as liquid as stocks in the Vanguard S&P 500 ETF(NYSEMKT:VOO). Because they are new, these products are untested in a downturn.

Finally, there are limits to the efficacy of passive investing. After all, index funds are agnostic when it comes to value; they aim simply to replicate an index. For a capitalization-weighted index such as the S&P 500, the more an index component becomes overvalued, the heavier its weighting in the fund. That, in turn, creates opportunity for active fund managers -- assuming they have an eye for value in the first place.

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